Watch your P's and E's

Mark Hulbert passes on some advice from Clifford Asness and Anne Casscells:

To understand Asness' and Casscells' argument, consider the following statement. It, or its functional equivalent, is repeated so often by investment newsletters and on Wall Street that we're likely to accept it as a legitimate argument, even though its reasoning is faulty.

The statement goes: "Based on analyst estimates for 2006, earnings on the S&P 500 next year are likely to total $X, which results in a P/E ratio of Y. That's right in line with that ratio's historical average of about 15."

Did you catch the sleight of hand inherent in it?

According to Asness and Casscells, the problem with this reasoning is that it compares a P/E ratio calculated using forward earnings with past P/E ratios calculated using trailing earnings. Since analysts invariably project earnings to grow, P/Es based on forward earnings will always be lower than those based on trailing earnings.

A legitimate historical comparison therefore requires comparing current and past P/Es that are all calculated using trailing earnings - or comparing today's with historical ratios when all are calculated based on forward earnings.

Consider first the ratio calculated using trailing earnings. For the trailing four quarters, according to Standard & Poor's, reported earnings per share for the S&P 500 have totaled $67, which results in a current P/E ratio of 18.7. Between 1871 and 2003, according to Asness and Cascells, the median of P/E ratios calculated in this way is 13.7.

Based on trailing earnings, therefore, the stock market's current P/E suggests that the market is 36% overvalued.

Consider next the ratio calculated using forward earnings. According to S&P, analysts are projecting total operating earnings per share for 2006 to be $88.59, which yields a P/E ratio of 14.2. The median of comparably-calculated P/E ratios for the 1871-2003 period is around 11, according to estimates from Asness and Casscells.

So according to this approach to calculating P/E ratios, the market is 29% overvalued.

I do intend to be out of large cap stocks before the end of the year.